Hedge Funds Work for Yale, but Will They Work for You?

DEEP-POCKETED investors have done famously well by depositing some of their surplus millions in hedge funds. The Yale University endowment, for example, has relied heavily on hedge funds over the last two decades to earn annual returns of more than 16 percent a year.

Tempted to try to earn returns like those yourself by finding a way to include hedge funds in your own, more modest portfolio?

A fund of hedge funds -- which contains investments in at least several individual hedge funds -- may seem to be the solution. Not only do funds of funds offer some diversification, but they also generally require a lower initial investment than individual hedge funds, and they can be bought by people whose bank accounts are merely large, not colossal. And many hedge funds of funds are registered with the S.E.C., providing more transparency and oversight than is true for unregistered funds.

Well, as it usually turns out in investing, finding the right fund of hedge funds isn't all that easy. Comparable data for different funds of funds is not readily available. What's more, David F. Swensen, the chief investment officer of the Yale endowment, says that most investors shouldn't even bother to look for one.

One fundamental problem is that hedge funds, by their very nature, can be difficult for outsiders to evaluate and understand. Many hedge fund managers like it that way because they generally want to keep their strategies to themselves. And those strategies tend to be complex. After all, if a hedge fund simply mirrored the Standard & Poor's 500-stock index the way an index fund does, there would be no point in investing in it; there are plenty of index funds available with fewer restrictions and much lower fees.

The Securities and Exchange Commission is trying to bring more discipline and transparency to the industry by requiring many hedge fund advisers to register with it and to provide more data about their operations. The rules, which go into effect in February, were formulated while William H. Donaldson was the S.E.C. chairman. "Even wealthy, sophisticated investors, who shouldn't need people looking over their shoulder when they put money into hedge funds, have run into problems, " said Mr. Donaldson, who left the agency in June. "That means that smaller investors may need more protection, too."

For most investors, though, the new rules are not likely to make a significant difference, some experts said. One reason is that most funds of hedge funds marketed to people of modest wealth are already required to register with the S.E.C., according to Robert Rosenblum, a partner at the law firm Kirkpatrick & Lockhart and a specialist in hedge funds. Such funds are aimed at investors who may want to put up as little as $25,000 in hopes of finding an attractive alternative to traditional investments in stocks and bonds.

But while investors in mutual funds can turn to many services to rate and compare funds, there is no corresponding service that tracks and compares the performance of registered funds of hedge funds, partly because hedge fund trackers tend to cater to the very rich.

"For the most part these are not the types of investments that mainstream hedge fund investors, who are generally high-net-worth individuals and institutional investors, are interested in." said Joel Schwab, managing director of HedgeFund.net.

Registered funds of hedge funds tend to be assembled by banks and money management firms. Some are managed by one firm and then marketed by another. Each layer, starting with the underlying hedge funds, can tack on fees. An investor willing to do her homework can find a substantial amount of information about registered funds of hedge funds on the S.E.C. Web site, sec.gov, although the data may be difficult to interpret.

Consider the DB Hedged Strategies fund, started by Deutsche Bank in 2002. Smith Barney has been marketing the fund to clients who can put up as little as $50,000.

The S.E.C. site contains the fund's certified shareholder report, which includes performance data, the names of underlying hedge funds and the percentages of the overall fund that are invested in various strategies.

If you pore through the figures for the DB fund's overall performance, you will find that it has been disappointing, lagging behind the S.& P. 500-stock index from 2002 through 2004. Deutsche Bank plans to close the fund in 2007, citing "relative performance and dwindling interest in the fund."

What, exactly, were the fund's returns? That depends on how you look at them. The fund generated returns of 0.22 percent in 2002 and 10.71 percent in 2003, and declined 0.12 percent in 2004, if you include two layers of fees. Those are the fees of the underlying funds, typically a 1 percent management fee and 20 percent of the profits, as well as Deutsche Bank's charges -- an additional 1.95 percent in investment management fees and 0.25 percent in administrative fees.

An error has occurred. Please try again later.

You are already subscribed to this email.

But Smith Barney can also tack on a one-time sales charge of as much as 3.5 percent -- a fee that is negotiable and whose impact on performance is not shown in the documents.

Investors who paid the entire 3.5 percent up front would have earned a cumulative 6.9 percent return over three years; without the Smith Barney fee, they would have earned 10.8 percent.

No matter how you slice it, though, the fund didn't match the S.& P., which posted a cumulative 11.1 percent return over the period.

Mr. Swensen of the Yale endowment says the high fees on funds of funds are a big problem. Speaking of the entire class of funds, he said, "The fee structure, particularly when one adds the fees for the fund of funds, goes from unfair to ridiculously unfair."

How did the Deutsche Bank fund compare with other registered funds of hedge funds? It's hard to say, because there is no readily available source of data on them. Data on unregistered funds of hedge funds is available from a number of sources, sometimes for a fee, but it is not exactly comparable to data for registered funds. Smith Barney would not provide comparable data on the returns of the registered funds of hedge funds that it markets.

Mr. Swensen saw another fundamental problem: many of the best hedge funds are not available through any fund of funds. The most successful hedge funds, he said, often prefer to court only institutional investors who have longer time horizons. "The funds often want direct relationships with sophisticated investors," he said. "When times get tough the fund has the opportunity to convince investors to stay the course."

His skepticism comes despite the S.E.C. rule changes, which will require hedge fund advisers who manage more than $25 million and have more than 15 investors to register with the S.E.C. They will have to maintain certain books and records, have a compliance officer and provide information about their operations, among other disciplines.

But hedge funds that want to avoid government scrutiny can make use of a big loophole in the regulations. If a fund insists that investors lock up their money for two years, the hedge fund does not have to register.

Still, for funds that do register, "there will be more transparency and accountability," Mr. Rosenblum said, and that should help some investors.

AND for some investors, hedge funds may make sense. Paul Weisenfeld, Smith Barney's director of alternative investments, said such funds may help when "clients want to diversify away from equities and fixed income." Greg N. Gregoriou, associate professor of finance at the School of Business and Economics at the State University of New York at Plattsburgh, says that larger funds of funds, with assets of at least $200 million, are likely to have more staying power, and to have lower fees, than smaller funds.

"If they stay small, they won't be able to meet their operating expenses," he said. Funds that don't permit frequent withdrawals, he added, generally fare better than those that do, because they allow managers to execute their investment strategies at their own pace.

But in Mr. Swensen's view, most investors would be better off leaving hedge funds to the professionals, and sticking to traditional stocks, bonds and mutual funds. "Funds of funds allow unsophisticated capital to participate in sophisticated investments," Mr. Swensen said.